ELITE ADVISOR BEST PRACTICES
Winning Business Owners with Captive Insurance: The Basics - Part One
What advisors need to know about this powerful risk management and tax mitigation tool (first in a series)
By Randy Fox
- Captive insurance (or private insurance) is a form of customized protection for companies that may have trouble insuring their assets via conventional insurance channels.
- Captive insurance is a powerful risk management and tax mitigation tool for business owners who meet the right profile.
- Captive insurance can be a lucrative service offering for advisors who take the time to understand it well—and a great way to distinguish yourself from the competition for successful business owner clients.
Successful business owners are often a favorite target market for financial advisors. Business owners need a multitude of services that the advisor community can provide: retirement and pension planning, asset management, life insurance, disability insurance, buy-sell planning, succession planning, income tax planning, exit planning, and more. The list is seemingly endless, and the needs of business owners are ever-changing. In many cases, personal planning and business planning overlap so much that they seem inseparable.
Balancing the needs of a successful entrepreneur’s business and family life is often a challenge. Business owners are busy running their businesses and often have little time or patience for anything else that distracts them from their day-to-day routine. It’s hard enough getting them to listen to your ideas about financial and estate planning, let alone winning them over as clients. However, if you’re offering a unique product or service, one that few others are talking about, you can gain a competitive edge and differentiate yourself from other advisors. For business owners, captive insurance companies may be a solution you wish to consider offering.
Captive insurance (or private insurance) is simply provided by an insurance company normally established to provide insurance that is otherwise unobtainable or unaffordable to the business through traditional channels. This may include such coverage as business interruption, terrorism, fiduciary liability or a number of other risks. The captive company is regulated by the department of insurance in whichever state of our country it is domiciled and must look and act like an insurance company in every way. There must be true “risk shifting,” the company must be properly capitalized, premiums must be actuarially determined, and books and records must be properly maintained. Because of the inherent complexity of captive insurance, many businesses elect to use a professional “captive manager” to handle the day-to-day compliance issues. As competition has grown, the fees to establish and run captive companies have become more affordable for those seeking this type of customized insurance.
One of the best-kept secrets in the planning community, captive insurance has been widely available in the United States ever since Vermont enacted its captive statute in 1982. Prior to that, most captives were formed offshore, with Bermuda being the major center for captives. Currently 24 states have provisions for captive insurance companies. While Capstone Corp. and other industry watchers estimate that at least 80 percent of the Fortune 500 companies have formed their own captive insurance companies, very few smaller companies have yet to take advantage of the captive insurance strategy, even though special tax rules strongly favor their use. Traditional insurance companies, including large captives, pay income taxes on their earnings (excess of premiums over expenses). However, a special tax rule, §831(b), allows an exception whereby a captive may receive up to $1.2 million per year of premium and pay no income tax on earnings. In the right circumstances, this provision makes the “small” captive an ideal strategy for the closely held business.
IRS Code §162(a) describes ordinary and necessary business expenses and allows for the tax deductibility of those items that qualify. Most advisors know that property and casualty insurance premiums are generally deductible to a business, and, therefore, the dollars paid to the captive insurance company fall into this category. That means the business owner who forms his or her own small captive that qualifies under §831(b) has a tax deduction of the paid premium at the company level and no reportable taxable income to the captive. This kind of tax arbitrage represents tremendous financial leverage for the owner. While investment earnings of the captive are taxable, it is possible to structure the portfolio of the captive to minimize taxes. Thus, it is possible to build up a separate pool of assets completely outside of the operating business. This has many advantages and can provide great flexibility as part of the personal planning component for the owner.
Some caveats about captive
Captives aren’t appropriate for every business owner. They have a high degree of complexity and require the right combination of free cash flow available at the business level and business risk that needs insurance. The process of planning for, establishing, funding, managing and investing for a captive company is complex. The properly informed advisor is well-suited to manage the process on behalf of the business owner and to advise on the appropriateness of ownership structure, domicile, levels of funding, investment management and all of the other components that constitute a successful captive implementation. Better yet, there are significant compensation opportunities for advisors offering this type of engagement.
In future articles, we’ll dive deeper into the important details and risk of the captive structure. Minimum funding levels, general fees and establishment costs, onshore vs. offshore, capitalization, and opportunities for optimizing wealth transfer will be considered. The captive insurance company can be a powerful planning strategy for the business owner who meets the right profile. Advisors who wish to differentiate themselves and attract successful business owners as clients should take steps to acquire adequate knowledge of the market for captives.